When Irish IOUs are Smouldering

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The clumsy tango between Germany and Ireland is severely unnerving the markets, as no one knows exactly who will take the bruises when the tumble comes. Which taxpayers? Which banks? Which shareholders? Which debtholders?

The German government's unwillingness to lead the dance right, left, forward, or back is understandable politically, but until the inevitable losses are allocated it will be perilous to be anywhere near this dancehall.

The German-led Irish bailout gives Ireland a time-out to solve its financial problems. But the €85bn headline number, equivalent to over 50% of Irish GDP and €18,000 per resident, is smaller than it seems. The funds must be benchmarked against what they are being earmarked for.

€50bn is tagged for public finances, which is substantial on the face of it. This will cover two years of public debt refinancing and deficits -- a significant window to achieve fiscal improvement. But this presumes -- and here is the rub -- that Ireland stops absorbing soured private bank debt into its public debt.

€35bn of bailout money is tagged for Irish banking sector recapitalisation. Though this too may sound like a large sum, it is grossly insufficient without a U-turn in market sentiment. Over €34bn of foreign deposits fled Irish banks in September. €49bn departed in October. Meanwhile, Irish bank dependence on European Central Bank funding has soared from 2% of total liabilities in January 2008 to over 10% today.

How do Irish banks tap ECB funding? This is perhaps the ugliest part of the bailout sorcery. The Irish National Asset Management Agency (NAMA) was set up in 2009 to clean up the banks' balance sheets. But it does this by giving the banks newly conjured Irish government IOUs -- not euros -- in return for dodgy debt. The banks in turn dump the IOUs on the ECB, which then provides the actual cash. Since NAMA swaps IOUs for bank debt with a haircut of up to 50%, the three-way transaction can result in a €1 capital loss for every €1 the banks get from the ECB. Of course, the Irish government IOUs now lodged with the ECB may themselves have to be written down.

What is the logic of this crazy carousel? German banks hold at least €48bn in Irish bank debt, French banks €19bn, and British banks €31bn. Since June 2008, German, French and British banks have withdrawn €253bn worth of credit from Irish banks and other Irish borrowers -- 70% of the total foreign funds withdrawn. These governments are now trying to shield their banks from losses by feigning neighbourly concern for the Irish government.

But just as US taxpayers were outraged to learn that their money was used to make whole AIG's foreign bank creditors, Irish taxpayers are becoming similarly outraged as they learn the nature and size of the foreign bailout they are at least partially funding. It is politically unsustainable.

The markets know that the carousel must stop sooner or later. At present, though, they are struggling to divine what this will mean for holders of Irish bank debt, holders of Irish public debt, holders of equity and debt in exposed European banks, and holders of debt issued by European governments which opt to absorb their banks' debts into public debt. The web of potential private and public exposure is vast. And the so-called European Stabilization Mechanism, which is supposed to kick in for crises beginning after 2013, is sending a confused message about where the sluice will be open for private losses and where it will be closed by credible public guarantees.

So what is to be done? The least bad approach is to close the sewage pipes pouring toxic debt from Irish bank balance sheets into the Irish public balance sheet, and ultimately into the ECB's balance sheet.

This will require what gentlemen bankers call a restructuring -- otherwise known as a default. Default will finally allocate the inevitable private losses, and give the Irish government genuine breathing room to cut its mammoth deficit. Many exposed European banks will have to raise fresh private or public capital, and some may have to be resolved. This will be painful. But in lifting the cloud of uncertainty that is paralysing investors, it is a necessary first step on the road to a European economic recovery.

Of course, Greece, Portugal and Spain still stand in the way. But, hey -- had you asked the Irishman for the road to Dublin, he would have warned you not to start from here.

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